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Inexpensive Ways To Hedge SPY

Jan 24, 2013David PinsenHere are a few inexpensive ways to get downside protection on the S&P 500 Index ETF SPY.

Low Implied Volatility For the S&P 500; Lower For SPY

On Wednesday, Bloomberg TV reporter Adam Johnson noted that, while the S&P 500 Volatility Index (^VIX) is near a 6 year low, hovering near 12.5, the volatility measure of the SPDR S&P 500 index tracking ETF (NYSEARCA:SPY) is even lower -- at about 5. Consequently, Johnson noted, puts on SPY were cheap. In the link in his tweet below, he suggests that long equity investors consider hedging now, with the market near five and a half year highs, and the price of downside protection cheap.

Johnson suggested investors look at the at-the-money March SPY puts, which, as of Wednesday's close, would cost about 1.8% of position value.

Cheaper Ways to Hedge SPY

Johnson is right that SPY puts are cheap now, but there are less expensive ways to hedge, over a longer time frame, depending on how much of a downside you are willng to risk. The screen shot below shows the optimal puts* to hedge 100 shares of SPY against, respectively, a greater-than-10% drop, and a greater-than-15% drop between now and June.

Unlike the March expiration put Johnson mentioned, the optimal puts above would provide protection until late June.

Effect Of Low Volatility On SPY Collars

In a previous post ("Two ways of hedging Apple and RIMM"), we saw an example of a security that was expensive to hedge with optimal puts, but had a negative hedging cost with an optimal collar: the cost of buying its expensive put options were more than offset, in that case, by the income from selling its expensive out-of-the-money calls. The opposite is the case with SPY today: its put options are cheap and its call options are cheap too, so the income from selling those call options doesn't reduce the already-low hedging cost much. The screen capture below shows an example of this, with an optimal collar on SPY using a 10% cap and a 15% threshold (i.e., an investor opening this collar would be willng to limit his potential upside between now and June to 10%, in order to reduce the cost of hedging against a greater-than-15% drop in SPY between now and then).

Given the low cost of SPY puts now, I doubt many investors would be willing to cap their upside at 10% over the next five months just to shave 20 basis points (0.20%) off of the cost of their downside protection, but I've included the optimal collar screen capture above for illustration purposes.

*Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armoruses an algorithm developed by a finance Ph.D to sort through and analyze all of the available puts for your stocks and ETFs, scanning for the optimal ones.

**Optimal collars are the ones that will give you the level of protection you want at the lowest net cost, while not limiting your potential upside by more than you specify. The extension to the Portfolio Armor algorithm to find optimal collars was developed by a post-doctoral fellow in the financial engineering department at Princeton University. This capability is currently available on the web version of Portfolio Armor, and will be available soon as an in-app subscription for the iOS app.